The only certainty in the ever-changing business world is uncertainty. And this uncertainty can make it problematic to repay a business loan, especially one that you’ve personally guaranteed.
Equity financing, however, is a refreshing alternative that doesn’t dip into your early-stage cash flow and avoids the hassle of early repayment. Instead, it allows businesses to raise capital in exchange for a piece of the company.
But one issue remains paramount when it comes to equity financing: valuation. How do you valuate an early-stage business with no historical financial data? Unfortunately, there’s no clear answer.
We’ve summarized six different valuation methods below specifically geared towards early-stage businesses. Ideally, you should combine several methods for the most accurate valuation possible, which will help you understand how much your company is worth. It’s also helpful for determining the amount of ownership you should be offering, and the price at which you hope to sell it.
1. Comparable Transactions
An inherently extrinsic approach, this method looks at recent valuations of similar businesses in the same industry. If comparable businesses have been recently sold or funded, the valuation of those businesses can serve as your initial negotiation benchmark.
This valuation method is particularly useful if you have multiple comparable businesses. The more comparable businesses you have, the stronger your negotiating position will be. You can use websites such as BizBuySell and BusinessesForSale to determine the valuation of comparable businesses.
2. Discounted Cash Flow
While the comparable method assesses extrinsic value, discounted cash flow (DCF) measures future intrinsic value. Since DCF looks toward future earnings rather than historical earnings, it’s particularly effective for early-stage businesses.
DCF analyzes future free cash flows discounted by the weighted average cost of capital. In order to be useful, DCF should analyze future revenue models, not future revenue projections. Many investors will scoff at revenue projections, especially for early-stage businesses.
Although DCF sounds complex, it’s rather straightforward. It simply estimates how investment funds will affect your future cash flows while discounting the time value of money. After running the DCF analysis, if the future price of your company’s shares is higher than the current share price, it’s deemed an attractive investment. If the future price of your company’s shares is lower than the current share price, it’s an unattractive investment.
3. Exit Strategy and Investment Stage
An exit strategy is a liquidity event wherein investors cash out on their investments. Whether it’s an acquisition from a larger company or going public on a stock exchange through an initial public offering (IPO), your company’s exit strategy plays a role in attracting investors. For example, investors might be hesitant if your company is aiming for an IPO, since they are rare and difficult to achieve.
The main issue for potential investors is how much return on investment they’ll receive, and how long it’ll take to cash out. Investors expect to recoup anywhere from three to 10 times their initial investment, and they typically expect this return in three to six years.
Some investors may prefer investing early in your company’s lifecycle, whereas established venture capitalists and private-equity firms prefer investing later for a surefire return. Early-stage investors typically assume more risk but expect a higher return on their investment. Your ideal investor and valuation will hinge on your company’s investment stage and its preferred exit strategy.
4. Potential and Talent
At its core, your company’s valuation depends on the tried-and-true economic principal of supply and demand. If your product lies in a high demand industry with low market supply, investors will come knocking with offers aplenty. If you operate in an overly saturated market with numerous competitors, your chances of attracting investors are slim unless you have a distinct competitive advantage. Investors will get a glimpse of your business’ value by assessing your earning capacity based on market demand.
In addition to market potential, your company’s talent also plays a role in valuation. The more relevant experience your company’s leadership has, the more likely you’ll achieve product/market fit. Since most investors prefer to see early evidence of market traction, your talent plays a pivotal role in establishing that early traction and in turn attracting investors.
Your mission is to convince investors that their investment will lead to more traction and a larger market share, since their investment can be used to ramp-up marketing.
5. Asset Valuation
A realistic and popular method, asset valuation places a value on all of your business’ assets and subtracts liabilities to arrive at a final valuation metric. As such, you’ll need an updated balance sheet to briefly sum up your business’ assets and liabilities.
Business assets are defined broadly as anything that has market value. Assets include vehicles, machinery, equipment, copyrights, trademarks, patents, customer lists and more. Your business’ leadership team and employees also have value, and investors can place a monetary value on each employee, which they will add to the total valuation.
Conversely, liabilities include payroll, accounts payable and business debt. Ideally, your company will have diversified assets with minimal liabilities.
6. First Chicago Method
Specifically created for early-stage businesses, the First Chicago method provides three projections: the best case scenario, the worst case scenario and the expected scenario. Each scenario is assigned a probability (i.e. best case 25%, worst case 30% and expected 45%). Each scenario is assigned a monetary value, and the scenarios are averaged based on their probability to arrive at a final valuation metric.
Since future cash flows are speculative, the First Chicago method properly allocates risk to each scenario based on the accuracy—or inaccuracy—of future cash flows. Investors may prefer to see how their investment will play out in each scenario as downside protection, which is why the First Chicago method is considered by many to be the most accurate valuation method for early-stage businesses.
Early-Stage Business Valuation: An Art, Not a Science
Valuating early-stage businesses is more of a negotiation art rather than a mathematical equation. Convince investors your business has value and illustrate why they’ll benefit by investing in your business. Oftentimes, investors will invest in you rather than your business idea. Be passionate and bold about your business. Because if you aren’t, investors won’t be either.
For more information on company valuations, read our article on the four reasons a business owner would want to perform a company valuation.